Investor interest and strong pandemic performance has led to a proliferation of thematic funds, but niche themes can also be risky and their outperformance difficult to maintain over longer periods, a report from Morningstar Inc. says.
More than two-thirds of global thematic funds outperformed global equity markets (as proxied by the Morningstar Global Markets Index) in the year ended March 2021, according to a report from the Chicago-based financial services company.
“Since the beginning of the global pandemic, many thematic funds have chalked up impressive returns,” the report said, adding the caveat that their “success quickly fades when we take a step back and survey performance over longer periods.”
For the trailing five years, the success rates drop to 43%; over 15 years, only 22% of thematic funds outperformed global equities, and more than half of the funds shuttered.
“This lackluster long-term performance can be partly explained by the fact that thematic funds’ fees tend to be higher than those levied by their non-thematic counterparts,” the report said.
Last year saw 237 new thematic funds launched globally, up from 167 in 2019, making a total of 1,276 thematic funds as of March 2021. Global assets under management in these funds more than tripled to US$595 billion from US$174 billion over the last three years, the report said. (All figures that follow also are in U.S. dollars.)
Europe is the largest market for thematic funds, accounting for more than half of global assets, but the funds are gaining share in Canada: inflows of almost $600 million in the first quarter of this year set a record for Canada, and thematic funds now hold almost $2.5 billion, up from $52 million in March 2016.
Canada has 36 thematic funds, with many launched over the past few years and six debuting in the first quarter of 2021. Cannabis ($570 million) and energy transition ($380 million) are the largest themes by assets.
The report said many of the funds aim “to profit from emerging trends that are expected to grow rapidly in the near future.” And, Morningstar classified more than half as growth strategies, with only 15% classified as value.
“As in other regions, thematic fund launches in Canada have tended to track the market cycle, indicating that investors’ appetites for these strategies and the desire for providers to offer them typically move in sync with the broader market,” the report said.
“Fund providers have historically brought new strategies to market during periods of strong performance, like the new millennium and mid-2000s. But launches typically dry up during downturns.”
Horizons ETFs Management (Canada) Inc. was Canada’s largest provider of thematic funds as of March, followed by Evolve Funds Group Inc.
Fees on thematic funds in Canada are higher on average than for non-thematic funds in both active and passive categories. The report said higher fees have contributed to “relatively poor performance over longer periods.”
While more than 80% of Canadian thematic funds outperformed global equities in the year through March 2021, that drops to two in five funds over five years. Only two thematic funds in Canada have a 10-year track record and neither outperformed over 10 years, the report said.
Generally speaking, Morningstar said thematic funds can be useful as single-stock substitutes for investors looking to focus on a theme without conducting due diligence on individual companies — liquidity is a concern for funds tracking narrow themes, it said, as are single-name holding concentrations.
“Investors in thematic funds are making a trifecta bet,” the report said: picking a winning theme; picking a fund that will ride that theme and survive; and buying before the market has priced in the theme’s potential.
“The odds of winning these bets are low,” Morningstar said, “but the prospective payouts can be large.”